More Chemo, Less Voodoo

Friday’s release of the advance Q2 GDP figures, along with the benchmark revisions, will be cause for celebration … if somewhat subdued celebration. GDP grew at a 2.4% annual rate in Q2, marking the fourth quarter in a row of positive growth. The economy, that is, has been expanding for a full year. Critics might point out that real domestic final sales grew a fairly unimpressive 1.3%, and that overall growth has gone from 5% to 3.7% to 2.4% over the last three quarters even including the inventory building and the ample fiscal stimulus. Really mean critics, the kind that doesn’t get invited to parties, might observe that for all this growth and all this stimulus, the Unemployment Rate is unchanged from a year ago (at 9.5%), and expected to rise in this week’s report.

The GDP price index, expected to be +1.0%, was actually +1.8% although the core domestic price index was better-behaved at +0.9%. The Employment Cost index was +0.5%, a tick higher than expected with wages +0.4% and benefits +0.6%. The ECI is +1.8% over the last year, which is above the 1.5% trough rate experienced for 2008Q4-2009Q4.

The Chicago Purchasing Manager’s Index was much stronger-than-expected at 62.3 versus expectations for 56.0. My suspicion is that the non-shutdown by GM may have positively affected parts suppliers in the Chicago area. I don’t know how they seasonally adjust the Chicago PMI, and nobody mentioned that effect, but I would not be surprised to see it settle back next month. Moreover, I would not necessarily expect such a strong showing from the broader ISM report, due on Monday (Consensus: 54.0 vs 56.2), which was expected to soften but now probably has some higher “whisper number” attached.

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I was in a conversation this weekend with a reader of this column, and in reprising the general outlook we hit upon several observations that I think are worth making here about the lessons from Japan.

The first concerns the buying of bonds by monetary authorities. St. Louis Fed President James Bullard last week raised the specter of further Fed purchases in his discussion of how to avoid “The Peril” of Japan’s lost couple of decades. One complaint about this sort of policy is the obvious: by adding lots of money to the system, it can cause inflation (precisely what Bullard is trying to do, of course). But other people, pointing to Japan, say that “buying bonds doesn’t work. Japan never managed to generate inflation.

If this is true, then there is a wonderful opportunity staring us right in the face. If the Fed can buy all the bonds it wants, and not generate inflation, then we should be actively encouraging it to do so. Why? Well, if the federal government can spend trillions on all sorts of new programs, and have the Fed buy the bonds, and not have any ill effects, then why the heck shouldn’t we do that?! We can have our cake and eat it too. We can have tax cuts and profligate spending, and just have the Fed make up the difference. In fact, if there is any chance that this is the case, it is irresponsible to not try it. Everyone could be happy.

Now, I think most people are justifiably concerned that this sort of free lunch probably cannot exist, and for good reason. Everything about theory suggests that pursuing this policy would cause inflation. And we’re pretty darn confident in that theory, or as I said this would certainly be worth trying!

But back to the second objection, then: “Japan has been unable to arrest its deflationary tendencies.” My response to that has generally been dismissive, that they merely haven’t tried hard enough. In my previous comment, I said it was basically a question of dosage, and Japan never applied much of a dose.

Why is this so confusing to people? Why do people simply look at Japan and shrug helplessly? It sure looks like Japan tried very hard; according to CIA World Factbook (here) Japan as of 2009 estimates is behind only Zimbabwe in the size of its debt as a percentage of GDP, at 189%. Surely, they have tried hard enough, and failed. Are we doomed?

Wait a minute! Debt as a percentage of GDP is the result of Keynesian stimulus, not monetarist stimulus. In fact, the monetary actions, first ZIRP (the “Zero Interest Rate Policy”) and then quantitative easing or QE, were tentative, diminutive, and late. Japan, in trying to arrest the deflationary cancer, tried a little bit of chemotherapy (monetarist medicine) and lots and lots of voodoo (fiscal stimulus). The patient has not recovered, and other doctors around the world are despondent. “Nothing has worked!”

Here’s an idea – how about trying more chemo, and cut back on the voodoo? It sounds crazy, but it just might work.

The record on fiscal stimulus is poor. A decade of fiscal stimulus failed to jolt the U.S. out of the Great Depression; it failed to bring Japan out of its own depression; and it has provided a short-term boost in the U.S. lately but the jury is out on whether there has been any lasting benefit (it seems not). The contrary case is also interesting: the retraction of fiscal stimulus following WWII didn’t exactly cause the economy to collapse – in fact, it boomed – and the running of fiscal surpluses in the 1990s didn’t seem to take the shine off that expansion one bit. The only reason that with this rotten record fiscal stimulus keeps getting an airing in policy circles is because (1) it certainly seems like it should work, and (2) witch doctors are scary.

Meanwhile, everywhere you see rapid money growth, you get inflation. And despite the booming economy in the 1980s and 1990s, inflation declined as the growth rate in money also declined. It is hard to untangle the cause and effect from all of these examples, but the track record of the different policies is pretty different. Chemo seems to save many patients, and voodoo seems to kill most of them. I think Bullard is right, and I suspect we will find out in the next year or two.

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One final note – an interesting link was sent around by one of the Wall Street inflation desks. It is a comic book-style explanation of inflation. It isn’t bad, and really explains a lot of nuances about inflation. It is produced by the New York Fed, of all places. The link is here.

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I agree that it is possible to make the indicators lie. The repeal of the 18th amendment was orchestrated by the barrons of industry because they believed that an alcohol tax would lessen the government’s thirst for income tax. Instead, the government got larger and the income tax stayed the same.
Gradual policies dont have any “immediate cost.” But they reallocated wealth from future generations to the present one.
Japan is a good example. Look at the birth rate.